Repo Rate Cut & Likely Impact

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Repo Rate Cut & Likely Impact

On January 15, 2015, Reserve Bank of India (RBI), the Indian central Bank, decreased the repo rate by 25 basis points in an effort to give impetus to the expansionist forces of the economy. Repo rate is the part of Liquidity Exchange Facility of the RBI whereby it controls the injection of money i.e. liquidity into the economy. Among the many weapons in the arsenal of RBI by the virtue of which it controls the money supply, repo and reverse repo are used by it most frequently. Generally, when the economy is going through high inflation, central bank follows high interest rate policy and when it needs to give a push to the growth or there are deflationary pressures, bank follows low interest rate regime.

Rate Cuts and Prices

With the lowering of the repo rate by RBI, other commercial banks would also lower the interest rate on saving deposits and borrowings. With less interest on the saving bank deposits, a person would prefer to spend his money on durable goods rather than keeping them in the vaults of the bank. This would increase the aggregate demand and thus put upward pressure on the prices. With the crude prices at their lowest in five years, wholesale price inflation also within comfortable range, rate cut was expected from the central bank. Moreover, with government reiterating its commitment to contain the fiscal deficit as well and a general belief that crude prices are expected to remain low over the year, the upward pressure on the prices would be nullified by these factors. So this time, fall in interest rates are unlikely to cause rise in prices in short term.

Rate Cuts and Stock Market

At lower interest rates, businesses will enjoy the ability to finance their expansion at a cheaper rate, thereby increasing their future earnings potential, which, in turn, leads to higher stock prices. Investors too prefer to move money away from the bond market to the equity market as bond market gave less return due to falling interest rate while stock market witnesses upward swing.

Rate Cuts and Exchange Rate

The interest rate cuts lead to the depreciation in foreign exchange rate as foreigners find it less lucrative to park their funds in the country with lower interest rates. Thus, when the interest rate is lowered in a country, foreigners often look for some other destination giving higher returns which led to the flight of capital. The flight of capital causes depreciation of home currency. However, this is more applicable in case of sudden fall in interest rates and not in case of gradual and deliberate reduction in rates. A depreciating currency makes the imports costlier and exports cheaper. So rate cuts also have favorable impact on balance of payments.

Interest rate Cuts and Loans

As per the theory, an interest rate cut should be followed by the cuts in lending rates by other banks. However, banks protect their margins, first cut the rates on FDs and RDs before reaching for the loan rates. In the recent past, banks have refused to bring their base rates below the 10% mark, despite significant deceleration in loan growth. Though banks may do some token cuts to pacify the RBI, no major cut in lending rates are expected.

However, the aforesaid affects are applicable only in case of ceterusperibus situation i.e. when other factors are constant. But in reality, since many factors simultaneously act in an economy, the resultant effects often differ from what postulated by the theory.

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